I’ve been having an interesting chat about the arguments in favour of removing deferred tax from the consideration in the Fair Tax Mark method. Personally, I think it can seriously distort the results and thought an illustration of the principle I’m concerned about is worthwhile for review.

It appears that the argument in favour of removing deferred tax is that over an extended period of time deferred tax differences reverse anyway. That is only true for timing differences which arise and reverse in the period itself, but because of the odd Fair Tax Mark weighting, even this occurrence distorts the calculation.

Here is a fairly innocuous looking example where profit is stable and corporation tax stays at 30%. A single asset (worth £60) receives first year allowances in year 1, is depreciated in a straight line over six years. The deferred tax asset movement in year 1 reverses in full over the next five years.

The argument that the current tax rate should naturally smooth itself means that the weighted rate should still come out at 30%. The deferred tax charge would “misleadingly” smooth the effective rate to 30% in all six years and produce a weighted average of 30%.

However, disregarding deferred tax produces this:

If I’ve got the Fair Tax Method right, my understanding of the reason to remove deferred tax is correct and I’ve not made a silly error, the Fair Tax Method produces a 2% difference in rate out of nowhere.

Given that a 7% swing turns a score of 5 to 0, I would consider this to be material.

Even then, this is just theoretical, but it tests only one variable for the removal of deferred tax: the weighting by year.

But if you throw in different profits, different rates of tax, different sizes in deferred tax movements and timing differences that do not arise, or do not reverse fully, in the six year period, then you might begin to realise why I am concerned.

Also, it is not the results of the method that are the “product” of the Fair Tax Mark, it is the method itself – the method should not be susceptible to producing anomalies like this.

8 Responses to Does this example regarding the Fair Tax Mark make sense?

I agree entirely. The whole point of deferred tax in accounts is to bring the tax position back to a fair one, to compensate for tax-specific rules which distort the current tax charge. The Fair Tax methodology however assumes that DT is designed to do the distorting.

The key explanation for why DT is removed is:

“…it is very important to realise this, the amount of deferred tax included in a set of accounts is determined not by tax rules, but by accounting rules, and those accounting rules are created by the accountants themselves.”

This is entirely backwards: the amount of deferred tax is determined by the tax rules. The amount of it you recognise is determined by accounting rules, but the underlying amount comes entirely from adjustments away from the figures the accountants would use to calculate the tax if it weren’t for the tax rules.

I think the problem is that Fair Tax thinks there are three measures of profit:
1) What accounting rules say the profit is;
2) What tax rules say the taxable profit is; and
3) What the profit really is.

There is an assumption that deferred tax comes from the areas where 1 & 2 diverge from 3. But I think that’s rubbish: I don’t know how one can reasonably establish a figure for 3 that isn’t 1 – given that the whole point of GAAP is to give a proper profit figure.

Quite apart from rate changes (appreciation of which is vital to the correct calculation of DT) the whole “smoothing out over 6 years” thing suggests a serious misunderstanding of structural deferred tax. The sort of very large business that Fair Tax is looking at tends to be growing, and so if it gets a DT liability it will only increase. The DT charges that Fair Tax ignores because they “may not be paid for at least forty years” are exactly this sort of thing, and are exactly what is intended by Parliament. If Parliament wanted DT always to be nil, then they’d start by giving a deduction for depreciation.

Outside deferred tax, as you say the methodology takes no account whatsoever of permanent tax adjustments which are specifically intended by Parliament, like R&D tax credits, or SSE. The only conclusion to draw is that such things are regarded as unfair, which seems an odd way to look at incentives deliberately introduced by Parliament. So we come back to the assertion that tax should be paid on what the profit really is – and it appears that, according to Fair Tax, neither accountants nor Parliament are competent to decide that.

Andrew, thanks very much for those comments. It’s reassuring to see somebody else set out a similar argument.

I hadn’t seen that quote on deferred tax being nonsense because accountants make the policies. Surely that undermines the approach of basing a fair rate entirely on the accounting profit?

Once you strip away the methodology, the “fair profit” that the rate of corporation tax is applied to is simply the accounting profit. So, taking on your three profits, they are arguing that 3 is actually 1. But then they ignore that the accounts already explain how 1 reconciles with 2.

Surely they should be analysing something on the tax reconciliation note to help comment on the difference? So if they see depreciation in excess of capital allowances, they can start worrying about how depreciation and capital allowances are interacting, or if it is down to losses, whether those losses are legitimate. And so on.

I think the key message is a deep distrust of anything that the company has any control over, such as accounting policies; but this is coupled with a disregard for tax legislation too, so I have trouble seeing what Fair Tax regards as the proper tax base.

The methodology does check to see how profitability in the UK relates to profitability elsewhere – looking at profit margins, and so on. So there is an element of scepticism concerning the measurement of profits in the accounts (I find it interesting though that the acceptability of the ETR depends on how it relates to the headline UK rate, though – there seems to be little acknowledgement that profits earnt overseas might properly be taxable at overseas rates).

The problem is that by assuming that there might be a proper profit figure 3, and therefore disregarding DT, but not defining how 3 is different from 1, we end up with the disregards making no sense.

I was thinking that a decent analysis of the tax rec would be the better way forward – I nearly said as much in my previous commment, but felt it was getting over-long 🙂 Perhaps the thing to do is to analyse the tax rec, to show how actual tax differs from expected (you could include an analysis of DT in there), and then do some separate work on the accounts to see whether there is anything odd going on with recognition or attibution of profit. Any unfairness in the tax position would be the aggregate of the two.

The question then is whether that should be done on a UK/everywhere else basis, or whether Fair Tax should do as much analysis of the overseas figures as they can on a country-by-country basis. Although I suppose that would just be the detailed work behind the “effect of overseas tax rates” line in the tax rec.

Having said that, I suppose the logical conclusion is that Fair Tax should actually be reworking the tax calculations based on any adjustments they think should be in there. After all, a basic premise of auditing is that you should form an expectation and then examine the actual position to see how it differs. On that basis Fair Tax should perhaps examine the attribution of profit first, to give a baseline accounts figure to adjust from, then work out the expected tax from that, and then bingo, we have our reconciliation from Actual Tax to Fair Tax.

I was looking at stuff all over that website and just gave up and looked at the numbers. There’s so much rhetoric under the methodology and resources tabs, it is difficult to follow their narrative as to what they are trying to do.

When I invited them for comment on my first blog, they said that I was missing the point. I reckon I am probably not alone in that.

A lot of this discussion comes up every time that the way of accounting for deferred tax is up for debate. Full provision does often mean that companies build up deferred tax provisions that never fully reverse. Investment happens on an ad hoc basis and is subject to inflationary increases – so the simple case where you invest in year 1 and the provision reverses in year 5 never really arrives. You always end up carrying a provision because the new timing differences swamp the old ones that are reversing.

In a relatively high inflation economy – such as the UK in the 1980s and 1990s, the partial privion approach made sense because otherwise companies ended up with enormous provisions that were never conceivably going to be used up. The accounts of comanies such as Shell and construction companies from those years display it quite graphically – esp the UK-US GAAP reconciliation where UK was partially providing and US was fully providing.

Ignoring deferred tax just creates another problem – that of differential depreciation rates and other causes of timing differences.

Graeme, thanks for your comments. I seem to recall somebody citing rising deferred tax provisions as a sign of avoidance. I suppose that would provide an alternative explanation of that happening.

Deferred tax’s usefulness to me has primarily in explaining a company’s tax charge in a given year. Once it is on the balance sheet I suppose it gets rather alienated from that concept until it is utilised. And where the magnitude of the asset or liability is relatively large compared to annual movements, the uncertainty as to when it will be used must be increased. But, it doesn’t necessarily mean it has no value.

My head starts to hurt when I think too much about deferred tax assets and liabilities… I will stop now.